Tuesday, May 12, 2015

Department of "Huh yourself!": British demand edition

Brad DeLong thinks I'm nutty when I say that Britain isn't obviously suffering from a persistent shortfall of aggregate demand:

There are no signs looking at wages and prices that this is due to any adverse supply shock...there seem to be no reasons looking at wages, prices, and output to believe that the British economy right now is a full-employment at-capacity-utilization economy. And only in such an economy would monetary and fiscal policies that boost spending simply boost prices and not production...
Does the fact that the employment share of British adults is actually high mean that the British economy is, in fact, at potential output? That stimulative monetary and fiscal policies risk rising inflation for no gain? And that it is time to normalize? Certainly Mark Carney at the Bank of England does not believe that is so:
From my point of view, why so many Britons have taken so many low-pay low-productivity jobs in the past three years is a mystery. But that they have gives us little reason to think that the British economy is now a full-employment at-capacity-utilization economy in which aggregate demand is now equal to potential output.

First of all, let's get a couple things straight. I don't think British stimulus would be particularly counterproductive, I just don't think austerity would be either. If there's not a big demand gap, multipliers shouldn't be large, so stimulus just won't do a heck of a lot (unless the UK has falling-apart infrastructure like we do), but neither will austerity. Also I doubt AS-AD is even always the right model for the macroeconomy.

But with that said...

With a demand shortfall, we ought to see high unemployment. We also ought to see low inflation.

In the U.S. we saw both of these in 2009-2014. In Britain we saw the former in 2009-11, and we never really saw the latter at all. Here is British core inflation:

The Bank of England's inflation target is 2% (whether that's a ceiling or a target is not certain). But in 2010-2013 - four years!! - UK core inflation was above that target.

So if we stick to the good old Econ 102 AS-AD model, and we look at both prices and quantities, we can come up with the following simple story for the UK:

1. In late 2008 the UK suffered a negative AD shock.

2. Around the same time, the UK suffered a negative AS shock.

3. In early 2010 the negative AD shock began to abate.

4. In 2012 the negative supply shock began to abate.

5. The differences between the UK and the U.S. in GDP, employment, and inflation can be explained by the fact that the UK's AD shock wasn't quite as big or long-lasting, while the U.S. didn't experience a supply shock.

This story also fits what we know about British TFP, which declined from 2007-2009, then flatlined through 2011:

This story is incredibly simplified, and uses a model that probably isn't the best. A real, careful, academic analysis of the situation is certainly warranted. But is there some obvious reason we need to go looking for a story where AD is the only thing moving around here? That story is going to have a lot more moving parts, and it's going to go a lot deeper into micro stuff.

And it will also look like reaching. Why should we demand a story where demand is the whole story? Is this about stabilization policy, or about the size of the British state?

I was more thinking along the lines of demand for things that can be made in a high volume, high productivity industries and sold euro wide being replaced with demand for things that are made on a smaller scale, less productively and sold in the local UK economy. So the UK would have enough demand but be more limited in the quality of that demand by factors outside of their control (controlled by the ECB).

I can't say for the UK, but I believe that many measures are similar to those in Germany and other EU states. Measures for boosting employment in Germany include the possibility to work in some industries for certain number of hours each month for below minimal wage, work as intern (unpaid or paid below minimal wage), and some other ways to work without actually being employed (having employment contract). All those people are counted as employed, but many of them earn even below poverty level.Germany also changed the way they count unemployed - those who search for jobs through private agencies and those who are over 58 years old are not counted as unemployed. All those measures resulted with record-low unemployment figures in Germany, but percentage of people living in poverty rose from 11% in 2001 (before reforms) to 15.5% in 2013, despite unemployment falling from around 10% to around 5% in the same period.As I said, those are results for Germany, but measures were suggested at EU level, Germany was just the most active in their implementation.

I suspect the UK's supply problems have more to do with the fact that their economy depends to a much larger extent than the US's on providing financial services to an international clientele. Stimulating domestic demand in the UK isn't much help to that business. Also financial services jobs tend to have higher wage flexibility than most industries, due to the large bonus component, which could help explain the puzzle of lower incomes without as much unemployment.

I agree with you, but I'm generally a skeptic of generalized stimulus, which even in the thick of an unemployment crisis is a very low bang-for-the-buck way of hiring the recently unemployed. We need to replace sit-at-home safety net programs with temporary employment programs. I agree US infrastructure is underfunded but cyclical ad hoc splurges is not the right way to fix it. Ad hoc whimsical "investment" in ideologically favored industries is just plain dumb.

This line is very true: "This story is incredibly simplified, and uses a model that probably isn't the best." But scratch "probably" and replace with "obviously." Your model assumes a closed economy. For Britain.

I hope I'm reading right your comments about "aggregate supply shock" and "declining TFP" as referring to the depleting North Sea fields, the productivity elephant in the room. A lot of people looking at Britain don't seem to realize that productivity reflects how low the natural resource fruit is hanging as well as the effectiveness of labor and capital. There are big penalties in productivity stats for a depleting resource bonanza.

There's a kind of parallel in the US oil industry. If you were watching the technology progress, you might think the sector's productivity growth must be through the roof. But the productivity trend in the US oil sector is weak. Because there are no rewards in productivity stats for the extra work you have to do to overcome tougher natural obstacles. If you're using more labor per barrel, your productivity is down.

Besides, at this stage in the cycle it's typical for productivity growth to be weak, as it is in the US, too.

When you're having a good time , sometimes you can chug away on a bottle of hard liquor for a surprisingly long time. Maybe even more than one bottle with even more good times. If you keep at it , however , eventually you'll stop. You'll either pass out , or puke , or die , or some combination thereof. There's no external "shock" involved - this is all endogenous to your drinking "economy".

It's the same with debt as with booze , and with debt , we call the resulting euphoria "increased aggregate demand" and/or "soaring asset prices". Most consumers in the UK , and in the US , have long since puked or passed out on debt , and are not about to take on much more , and even if they're willing , they're often cut off by their elders (lenders).

The lack of a housing recovery should be a pretty obvious clue , as you need housing debt to finance a housing recovery. The fact that large , luxury homes have been the only segment providing support to new home sales should be a clue about who is "constrained" and who is not.

The relatively early and quite vigorous recovery in auto sales should also be a clue. Why did auto sales recover so well , compared to housing and other consumer spending ? Because we engineered subprime 2.0 in the auto lending business by exempting dealers from the new consumer lending regs , to the great consternation of Liz Warren. More debt equals more demand for autos , but since incomes haven't gone up , it also means more eventual defaults from the debt drunks.

The entire global demand regime has been built on rising leverage instead of on broadly rising incomes , and that regime has now exhausted itself. Uniquely , economists seem unable to grasp this most important , and obvious , fact.

That economists are unable to grasp this state of affairs is my position as well. Although some of it is institutional bias, the rest is methodological bias: Macro is a correlative method, as opposed to micro, which is a causal method. Keynesian econ studies how much we can 'lie' to encourage economic velocity, Austrian econ studies how we can improve our truthful cooperation with one another to encourage economic velocity. You don't learn much about a correlative and descriptive model, unless you are able to express it as an operational sequence. And to some degree, while this operational description is unnecessary in the physical sciences because we do not know the first principles of the universe, is misapplied for convenient obfuscatory political reasons in to the social sciences where we *do* know the first principles of human decision making - we are each of us an exceptional instrument for testing the rationality of incentives.

They aren't weird. They're incorrectly incentivized, and insufficiantly chastized for what technically, is using untested (uncriticized) pseudoscience for the purpose of engaging in deciet, for the purpose of achieving full employment.

Now, once we get that this is an elaborate system of 'lying' not seen since the invention of scriptural monotheism, it's clear why the 'cult' cannot grasp reality.

That isn't to say most economists are bad people, any more than priests were and are, bad people. It's that they bought the nonsense, found a place in the church of the academy, and practice its rituals: correlative non-causal justification of deceit for ostensibly moral ends.

Of course, it is all about the size of the British state. Why do you ask?It is impossible for the financial complex to keep earning as much money if the state pretends to do "their" business in education, health, retirements or transports.Then we have the "macro" thing, and the "mediamacro" storytelling. But no one wonders or cares if multipliers are large: they are busy lobbying.And yes, the analysis you are trying to convey lies far beyond the reach of a AD-AS Model

There is something unusual going on with the UK. The low unemployment is good, but the deficit is still too high. Maybe higher labor productivity would generate more tax income? In most other countries, the deficit is cyclically related to the unemployment level. One would almost have to conclude that the technology level of the UK is regressing. That is the worst possible conclusion - a slightly more favorable interpretation is that the labor statistics are imprecise (effects of underemployment), or manipulated.I think that the post-crisis response in the UK was also unique in so far, as that the divergence between monetary stimulus and fiscal stimulus was uniquely wide. Monetary policy was very expansionary, but fiscal policy was contractionary and continues to be so. That's probably the reason why inflation was so high in spite of fiscal contraction, there was just so much money going around and the money multiplier, which must be an especially powerful force in a finance-dominated economy, pushed inflation upward.I wonder if the British dependence on finance, its quasi-monopoly on the political economy, is hollowing out the economy in a way that other skills wither away, and so the productivity declines. Though I guess, the oil price decline also plays a role in that, but the productivity puzzle already existed before that.

On inflation, it's worth noting that VAT (sales tax) rose from 15% to 17.5% in early 2010 and from 17.5% to 20% a year later. In addition there was a tripling of university tuition fees. Both these changes had a fairly significant effect on the inflation figures.

I think the real question is why inflation did not fall by more in the UK in 2009. Using Eurostat data, the (headline) rate of inflation fell by 5.2 percentage points in the US, 3 percentage points in Switzerland, 3 percentage points in the euro area, but by just 1.4 percentage points in the UK. Thereafter, changes in the UK's inflation rate track changes in rates of inflation on the Continent quite well (particularly for countries that also saw increases in the VAT).

"Abrupt and sustained bursts of inflation" might just be VAT increases and tuition hikes on top of the 2009 rate of inflation of 2.2%. Since 2011 - the last year of an increase in the VAT - core inflation has been falling sharply (as we can see in your graph above!), something we would expect if there is an aggregate demand story.

(All this isn't to say that there wasn't an adverse supply shock as well. After all, there's got to be a reason why inflation never fell as sharply as it did everywhere else.)

I'm not sure you really addressed Andreas Paterson's point about the VAT. The VAT increase was captured in the consumer price index. You could think of it as an upward shift in the supply curve causing a price rise across all commodities. That's really not the kind of inflation (at least measured inflation) that we associate with robust aggregate demand. So I think Brad's point stands and the fact that the measured inflation rate ticked up because of the VAT does not mean aggregate demand was okay.

Noah--very few, if any, people on the left want to increase the size of the state as an end in itself. A lot of people support government spending because they don't want to see their hospitals dismantled and so on, but no-one is thinking "boy I love a nice big government." That's what right wingers think left wing people think, because they themselves actually do want to shrink the state as an ideological goal.

>The Bank of England's inflation target is 2% (whether that's a ceiling or a target is not certain). But in 2010-2013 - four years!! - UK core inflation was above that target.

It's a symmetric target - as you note, the Bank's been happy to let inflation run well above 2% in the fairly recent past. The governor of the bank has to issue a public letter of explanation if the rate is more than 1% off target in either direction.

every country in close proximity to the Eurozone has done exceptionally bad. UKs current account deficit rose from 1% to 5.5% from 2010 to 2015. The reason probably at least partially was weak demand from the Eurozone. So maybe people had to wander from high value added sector jobs in the tradable industry to lower payed jobs in the service sector? That s the best i can come up with right now, it s probably not the whole explanation though.

One reason im sceptical this is the whole explanation is that the slump in UK gdp already started (very strongly) in 2009/2010 when the Eurozone was doing slightly better better than the US. So i would suspect the initial suspect somewhere in the financial sector that blew up and maybe that has not recovered on time as well. strong housing usually seems to lead to strong growth as well so quite a gap to fill here.